Archives for 2017 Tax Reform

The Tax Cuts and Jobs Act of 2017 provided significant changes to the net operating loss (“NOL”) system for corporate and individual taxpayers, including:

NOL can no longer offset all of a taxpayer’s net income in a subsequent year. Instead, NOLs can only offset a maximum of 80% of net income. For corporations, this rule effectively produces a 4.2% minimum tax rate on current year income, regardless of the magnitude of its NOL carryforwards.

NOLs can be carried forward indefinitely (instead of for only 20 years), but generally they can no longer be carried back to prior years.

These rules are generally effective for NOLs arising in taxable years after 2017; NOLs generated in prior years will be subject to the old rules. As such, businesses with historic NOLs will effectively have some phase-in time as they use up their historic NOLs.

Growth companies have few resources in abundance other than talent, enthusiasm, and NOLs. Unfortunately, these changes make the NOLs less valuable. Consider these situations:

Reaching profitability. If a growth company became profitable after years of incurring losses, NOL carryforwards could shelter its net income from tax for several years. Now, at least 20% of its net income will always be taxable. For a company with boom and bust years of alternating profits and losses, the timing of income and expenses is suddenly important; and they may want to find a way to “smooth” earnings if possible. Needless to say, this is a substantial complication in tax planning.

M&A targets. Growth companies going through an exit event may feel the sting in two scenarios.

First, a company that was never profitable may nevertheless have significant capital gains from selling its appreciated assets, like IP or goodwill. It may face a tax liability notwithstanding a bounty of NOL carryforwards. Worse, the target may then liquidate or otherwise not earn a net profit again, rendering the unused NOLs permanently worthless.

Regardless of deal structure, previously profitable M&A targets often generate net losses in the year of sale because of one-time, transaction-related deductions, such as sale bonuses, option cash-outs, etc. By carrying back the resulting NOL, the target or its shareholders could generate a nice windfall of extra cash in the form of a prior year tax refunds. Eliminating NOL carrybacks forecloses this strategy. Instead, owners of S corp and partnership targets will need to wait for future net income. Owners of C corp targets may try to negotiate a purchase price adjustment with the buyer. Although the NOLs may now be carried forward indefinitely, buyers will generally be ungenerous to such efforts. On top of the 80% limitation described above, annual use of the NOLs will still be generally limited by the Section 382 “ownership change” rules. Further, buyers traditionally chafe at the tax benefits sellers enjoy from paying transaction-related compensation and other expense, financed of course by the buyer’s cash.

The Tax Cuts and Jobs Act of 2017 may consist of more than 1,000 pages of statutory text and committee explanation, but the top headline is simple: “21% Corporate Tax Rate.”

More specifically, the graduated tax rates for C corporations that maxed out at 35% have been replaced with a 21% flat rate. Though broadly applying to all worldwide income of U.S. corporations, the consensus view is this dramatic rate cut has an international audience.

Related Legislative Changes

Repeal of corporate AMT. There would be no point to a new, flat 21% tax if corporations were still subject to an alternative minimum tax that kept their effective tax rate higher. The corporate AMT has been repealed. (In another post, we’ll describe how the individual AMT wasn’t repealed, but will apply to far fewer taxpayers.)

Reduced DRD. When corporations own stock in other corporations and receive dividends, the double-tax on corporate earnings distributed to shareholders can become a triple-tax, quadruple-tax, etc. To dampen this effect, corporations are entitled to a “dividends received deduction” (DRD) permitting them to exclude from income all or a portion of such dividends. The percentage of exclusion depends on the upper-tier corporation’s percentage of ownership of the lower-tier corporation. For dividends from ≥ 80% subsidiaries that could (or must) file a consolidated return, the DRD is and remains 100%. But as a revenue offset to the overall corporate tax cut, the DRD has otherwise been dialed back. For ≥ 20% subsidiaries, the DRD has been reduced from 80% 65%. For “portfolio investments” of corporations (< 20% ownership), the DRD has been reduced from 70% to 50%).

Some Practical Consequences

C corporations more attractive generally. The 21% rate obviously makes C corps more attractive as a form of business organization when compared to the top 40.8% rate that could apply to individuals earning flow-through income from S corps and partnerships. (The new top individual rate of 37% + 3.8% Medicare tax = 40.8%.) We will dive deeper into the choice-of-entity issue in a later post, but suffice to say this may change the choice-of-entity calculus for both new and existing companies.

Recompute the “double-tax rate.” A lot of business decisions, from choice of entity, to paying compensation vs. paying dividends, to preferred M&A transaction structure, require a rough application of the corporate double-tax rate, e., the aggregate taxes on $1 earned by a C corporation, which then distributes the after-tax earnings to shareholders. The double-tax has long been over 50%, and maybe over 60% counting state taxes. Now, once a C corp pays 21% corp tax and distributes the after-tax balance to an individual shareholder who is taxed at 23.8%, the maximum federal double-tax should be 39.8%.

Retained earnings — incentive & limitations. Of course, the double-tax only applies if a corporation’s after-tax profits are distributed as dividends. A C corp that retains its earnings can defer almost half of that tax until some indefinite future time. There are, however, important limitations on this strategy:

Shareholders may want or need cash. Not to be underestimated.

Accumulated earnings tax. Once upon a time, before Ronald Reagan, there was an even greater disparity between the top individual and corporate tax rates than prevails today. The C corp rate was 35%, but the top individual rate was a whopping 70%. Even when the top rate was decreased to 50% in 1981, dividends were taxed at ordinary rates. The rational and widespread retention of C corp earnings led to the “accumulated earnings tax” (AET), which imposes deemed-dividend treatment where a C corp’s retained earnings exceed “the reasonable needs of the business.” (Fun fact: the AET is one of the only federal taxes that is not self-assessed; it is only payable when imposed by the IRS.) Largely irrelevant during the decades of parity between the top individual and corporate rates, the AET may now make a comeback.

Personal holding company tax. Another product of sky-high individual tax rates, the “personal holding company” regime has renewed relevance. Certain closely held C corps with high proportions of passive income face an additional 20% tax. Be careful with that ingenious plan to put retained earnings to work in passive investments.

Section 269A and service corporations. The TCJA has prompted lots of speculation and criticism in the popular and business press surrounding whether employees can and should provide services through personal C corps. Read the fine print, in this case Section 269A, which authorizes the IRS to re-allocate income between an individual and a personal service corporation formed to provide service to a single employer. In other words, the IRS can ignore the corporation and treat the employer as paying the individual corp owner directly.

The Tax Cuts and Jobs Act of 2017 (“TCJA”), the most significant revision of the U.S. income tax laws in 30 years, is now the law of the land. We’ll be rolling out plain-English summaries of the most important business tax changes and what they mean to growth companies and their advisors, including the dramatic cut to the corporate tax rate, the 20% exclusion on “qualified business income,” a radically different approach to international taxation, important changes to net operating losses, and much more. We’ll also take a step back and assess how the TCJA impacts perennial tax questions for growth companies, like choice of entity, M&A structures, and equity compensation strategies.